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In Search of Balance

John Lim

“WHEN THE FACTS change, I change my mind. What do you do, sir?” Those words are sometimes attributed to Paul Samuelson, one of the the 20th century’s most influential economists. Due to a litany of cognitive biases—especially status quo and confirmation bias—letting go of cherished beliefs is easier said than done.

Which brings me to the topic of bonds and, more specifically, their role in the classic balanced portfolio of 60% stocks and 40% bonds. This mix is often the starting point for the moderate-risk investor seeking to balance risk and return. Since 1926, it’s generated an impressive 9.1% annualized return and has done so with far less volatility than an all-stock portfolio. Its worst year was 1931, when it fell 26.6%.

But one fact has changed over the past century, and it makes the historical record moot. Nominal interest rates are at rock-bottom levels—not just decade lows, but multi-century lows.

Bonds serve two primary roles in a portfolio: income and ballast. With bond yields near zero before inflation and deeply negative after inflation, income is not a great reason to hold bonds, perhaps with the exception of Series I savings bonds.

What about as ballast for a portfolio? A major appeal of bonds, particularly Treasurys and investment-grade bonds, is their relative price stability and the inverse correlation that bond prices often have with share prices. As I’m fond of saying, a bad year in the bond market can be matched or exceeded by a bad day in the stock market.

But investing is all about risk and return. With the 10-year Treasury yielding just 1.6%, is that measly return really worth the interest rate risk posed by potentially rising rates? In a 60-40 portfolio, a 1.6% bond yield contributes just 0.64% to the overall portfolio’s return, and that’s before taxes.

Furthermore, the great awakening of inflation could be a double whammy for bonds. First, real bond returns are reduced directly by inflation. Should the inflation rate persist at 6.8%, as it’s been over the past year, a 1.6% nominal yield equates to a real return of roughly -5%. Worse yet, if rising inflation leads to higher interest rates, bond investors would also suffer capital losses as the price of their bonds fall.

In short, traditional bonds may not protect investors as they have historically. A perfect storm of lower stock and bond prices is a real risk. What are the alternatives? While there are no perfect substitutes, here are some to consider:

1. Series I savings bonds and TIPS. Despite having negative yields to maturity, TIPS—Treasury Inflation-Protected Securities—do offer inflation protection. But they still carry interest rate risk, the risk they’ll fall in price if rates rise. That’s why I favor I bonds. Unfortunately, the amount of I bonds you can purchase is quite limited. Start buying some today.

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2. Immediate fixed annuities. It may seem ironic that annuities would be a bond alternative, given that insurance companies invest annuity premiums primarily in… bonds. But the secret sauce of annuities is mortality credits—money left over from annuitants who die earlier than expected. This boosts the income that annuities can provide and, at the same time, reduces longevity risk in retirement. Unfortunately, inflation is a very real risk if you own income annuities. If possible, you may want to ladder your annuity purchases.

3. Cash investments or very short duration bonds. Despite some famous naysayers who have recently called cash “trash,” think of short duration bonds and cash investments as the ballast in your portfolio. Yes, they will lose you money after inflation. But holding a small portion of your portfolio in these investments can be extremely valuable when markets go haywire, as they do from time to time.

4. Precious metals. For the record, I’m not a gold bug. But as an inflation hedge, I have a small allocation to gold and gold-mining companies. Gold has been a store of value for thousands of years and I’m betting that it will remain so. I view my allocation to gold as an insurance policy. A 5% to 10% allocation seems reasonable given the unprecedented degree of monetary stimulus.

5. Cryptocurrencies. Just kidding. My apologies to crypto HODLers.

John Lim is a physician and author of “How to Raise Your Child’s Financial IQ,” which is available as both a free PDF and a Kindle edition. Follow John on Twitter @JohnTLim and check out his earlier articles.

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Roboticus Aquarius
Roboticus Aquarius
10 days ago

Good Discussion.

Another option that some people have access to in their 401K’s (only) are Stable Value Funds. These are basically bonds with an insurance wrapper to guarantee a stable return. Mine has very strong insurers and has consistently carried a yield greater than the SEC yield for 10 year bonds, so I have virtually my entire bond allocation in this fund. However, top-rated insurers are critical, imo, to investing heavily in such a fund. Also, like regular bonds, there is no insurance protection in a Stable Value Fund.

Those yield differences are growing smaller over time, and I’m likely to move some of my fixed income allocation back to standard treasuries and tips if the yield advantage continues to shrink.

Philip Stein
Philip Stein
10 days ago

A minor nit, but I thought I’d mention it. It may be a bit misleading to think of cash accounts losing money after inflation. Thinking in nominal terms and in the absence of withdrawals, a cash account balance will never decline. I think it’s important to note that the principle risk of a cash account during inflationary times is declining purchasing power, not a loss of money per se.

That said, I agree that having liquidity available to purchase assets on the cheap during a market crash outweighs any short-term decline in purchasing power.

Mike Zaccardi
Mike Zaccardi
12 days ago

9% on stablecoins isn’t bad. Perhaps a good place to park cash if you are saving up for a boat, but not a house. I have some money in GUSD on BlockFi. I got sick of that 0.50% Marcus rate.

Harry Crawford
Harry Crawford
13 days ago

Sallie Mae also offers .50% on its money market account. Its High-Yield savings account is only .35%. I don’t know if they offer a higher rate to AARP members.

David Powell
David Powell
14 days ago

Your inflation point about annuities was my top concern when we bought our first in 2020. We’re laddering the remaining purchases as you recommend.

The investments backing annuities at the most credit-worthy providers is an interesting mix. Bonds, yes, but also some real estate, loans to life insurance policy holders, and a bit of equities.

Charles Price
Charles Price
14 days ago

My apologies…I just read the citation.

Charles Price
Charles Price
14 days ago

Perhaps I’m mistaken but I believe that the quote at the start of this article is generally attributed to John Maynard Keynes…

Jonathan Clements
Admin
Jonathan Clements
14 days ago
Reply to  Charles Price

You can read about the quote’s origin here:

https://quoteinvestigator.com/2011/07/22/keynes-change-mind/

Harold Tynes
Harold Tynes
14 days ago

The interest rate risk is real but I would not assume equities would offer past returns in a high inflation economy. I try to moderate my interest rate risk with a mix of individual muni bonds and corporate bond funds. I don’t go beyond 7 year maturities. The Ishares IBonds IBDO (2023 maturities) through IBDU (2029 maturities) create a good corporate bond ladder. Of course, I’m all in on I bonds but the amount you can purchase is limited. I still have some from early 2000’s and yield is over 8%! There are other one off fixed income opportunities out there such as Toyota Income Driver Notes, Synchrony Bank, etc.

Andrew Forsythe
Andrew Forsythe
14 days ago
Reply to  Harold Tynes

Can you please elaborate on the fixed income opportunity at Synchrony Bank?

Harold Tynes
Harold Tynes
14 days ago

Synchrony Bank is FDIC insured and generally offers savings rates at the high end of other banks. Currently offering 0.50% on High Yield Savings with ability to transfer funds to a sister Money Market checking account offering 0.35%. They also offer 0.70% for 14 month CD’s.

Michael1
Michael1
14 days ago
Reply to  Harold Tynes

FWIW, Ally has rates that are usually competitive with Synchrony. Sometimes they’re slightly lower, but then Ally’s early withdrawal penalty is more lenient. The choice is a personal one.

Andrew Forsythe
Andrew Forsythe
14 days ago
Reply to  Harold Tynes

Thanks. And I’ll pass one on which I likewise learned of from a HD commenter: My wife and I are each currently getting 1.10% on our savings accounts at Marcus. Current base rate is .50% and there is an additional .50% for 3 months when you refer someone—I referred my wife and we each got the bump. Plus there’s an additional .10% for 24 months for AARP members.

Jim Burrows
Jim Burrows
14 days ago

I keep my emergency fund in I bonds and about half my bond holdings are in a ten-year ladder of TIPS. The other half of my bond holdings are in short-term investment grade or Treasury bonds. Holding every TIP to maturity allows me to avoid any capital loss from an increase in interest rate. This soldi ballast of bonds, that can cover ten or more years of my living expenses, allows me to take a long-term view of my stock holdings while I sleep like a baby!

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